How to Review a Commercial Real Estate Appraisal Report: How Can an Attorney Ascertain the Merit of an Appraisal?
How to Review a Commercial Real Estate Appraisal Report: How Can an Attorney Ascertain the Merit of an Appraisal?
Stout Journal: Before even discussing the appraisal report, perhaps we should address the merit of the appraiser performing the work? What should attorneys look for in determining whether or not the appraiser is qualified for the matter at hand?
John W. VanSanten: At the most basic level, the appraiser should certainly be licensed within the state where the property is located. And this really is a minimum requirement, because while licensing requirements vary among states, they are not overly burdensome to acquire, and many of them allow reciprocity or temporary licenses. In addition, it is preferable to have the MAI designation from the Appraisal Institute, which is really the preeminent professional association out there for real estates appraisers. An appraiser who holds the MAI designation should possess a high level of experience and qualifications. But in addition, and sometimes more importantly, an appraiser possessing real estate expertise specific to the subject property and market area is key.
Stout Journal: Are there particular property types for which specific experience may be more relevant than for others?
JWV: Experience is certainly relevant for every property type, but it is more important with some special purpose properties. By special purpose properties, I am referring to real estate which has been designed for a unique purpose, such as a stadium or perhaps certain health care facilities. Special purpose properties typically have few, if any, alternative uses due to the high cost in making modifications. Since these properties are less common relative to office buildings or industrial parks, many appraisers simply do not have experience with them.
Stout Journal: As it relates to the appraiser, how can someone reviewing a report investigate the credentials of the appraiser?
JWV: There are a couple of resources which are generally available to the public. First, to verify if a person actually holds the MAI designation, you can use the “Find an Appraiser” function on the Appraisal Institute’s website which is www.appraisalinstitute.org. Second, with regard to licensing and state certification, the website for the Appraisal rel="noopener noreferrer" Subcommittee, which is www.asc.gov, can be used to determine if someone is actually licensed, if the license is current, if there have been recent violations, etc.
Stout Journal: Turning our attention from the valuation expert to the valuation report, I understand that there are various types of reports: Self-Contained, Summary, and Restricted Use. Is there any difference among them as far as the scope of the work performed, or is this merely a matter of presentation?
JWV: It is really just a matter of presentation as all three require the same amount of work. But depending on the context for which the appraisal is being utilized, presentation can be important. For example, in litigation, some attorneys may want a Self-Contained report, believing it to be impressive through its exhaustiveness, while others may believe a Summary report is more appropriate to minimize unnecessary questions on matters with little relevance during cross examination.
SRR Journal: Real estate appraisals, unlike business valuations, specifically discuss and ascertain the marketing period and exposure time for the property. Would you please discuss how these concepts influence value? And what should be done in determining these assumptions?
JWV: Exposure time is a retrospective look which answers how long a property had to be exposed to the market prior to selling on the valuation date. Marketing period is a prospective analysis. How long will the property have to be on the market from today in order to sell? If the real estate market is relatively stable, then these two concepts are going to be very similar in duration. However, if the market is appreciating or depreciating significantly, the time periods may be dissimilar. The relevance of these concepts really relates to consistency. If they suggest an appreciating market, has this translated into a higher conclusion of value?
Stout Journal: Regarding the scope of work, can you think of any particular documents or areas of investigation that, if they are not performed, could significantly impact the appraiser’s opinion?
JWV: The most obvious red flag would be the failure of the appraiser, or at least someone from his or her team, to have inspected the property. There are instances where the Scope of an Assignment has been limited to the point where a physical inspection is not required. In those cases, the appraiser has to make specific assumptions regarding the condition of the property. However, in matters involving litigation, an actual physical inspection of the property can be very important.
Stout Journal: What other critical subjects within a report should be reviewed?
JWV: The market analysis. Has the appraiser properly identified the correct market for the property? For this situation, think of the very small industrial property which has a local or regional market versus the Willis Tower where the market is national or perhaps even international. Who are the potential buyers/investors? Are they looking for properties locally, regionally, nationally, or internationally? The market analysis will dictate the search for comparable properties and ultimately which are chosen for indications of value.
SRR Journal: As a matter of protocol, would you recommend that sources of market information always be disclosed within the report? For example, if you were utilizing private databases, would you recommend that these databases be cited as well as how the search was conducted?
JWV: Whenever possible, the appraiser should communicate how the information was gathered, and how it was verified. For example, even widely utilized resources, while great for information, possess inaccuracies. And since our conclusions may be highly sensitive to the information reported, it is critical that verification occurs with public records and/or a party to the transaction such as the buyer, the seller, or the broker involved. Not only will this confirm the accuracy of data, but it will also allow the appraiser to understand the motivations at the time of sale and whether or not it is an arm’s-length transaction.
Stout Journal: Should the verification itself be cited within the report? Who was consulted, when, and in relation to what particular transactions?
JWV: Whenever possible. I have witnessed too many litigious situations whereby an attorney crosses an expert only to have their verification non-existent or poorly documented. It really diminishes the credibility of the analysis.
Stout Journal: Any valuation is performed as of a point in time, but, especially in today’s real estate market, there are rarely transactions that occur as of a particular valuation date, so past information must be reviewed. How far back in the past is appropriate? Is it six months? Two years? What is reasonable?
JWV: It largely depends on the extent of price volatility in the market. In general, you want to stay as current as possible, but in recent years it has been extremely difficult to do so given the dearth of transactions out there. In addition, it varies from situation to situation and depends on the quality of data available. Typically only transactions within the last year or two are utilized, but it depends on the situation and the type of property being valued. To the extent market conditions have changed from the time of the transaction to that of the valuation date, adjustments should be made.
Stout Journal: Moving on to the concept of highest and best use, it strikes me to be of tremendous significance to the appraisal, but I get the impression that it is not fully examined by a lot of appraisers as well as the reviewers of appraisal reports. Would you agree with that, and if so, is it an area which should be critically examined?
JWV: Absolutely. I think a lot of times appraisers tend to gloss over this concept, which can be a significant problem as it is a pivotal analysis underlying the entire appraisal. If the highest and best use analysis is wrong, the valuation conclusion is likely to be wrong. Many appraisers simply assume, “well, it is an industrial property, so the highest best use is as industrial property”. That may or may not be true. The analysis of highest and best use should look at the property twofold. First, what would be the highest and best use if the property was vacant and available for development? Second, what is the highest and best use of the property as currently improved? There are four sets of criteria which help ascertain this: legal permissibility, physical possibilities, financial feasibility, and the maximum productive use of the property. Ultimately, the conclusions related to the highest and best use of a property should reflect how the universe of potential buyers would assess the investment opportunity.
SRR Journal: I imagine the test criteria you just described lend themselves well as to questions to ask the appraiser: Did you examine what is legally permissible for the property as if it were vacant? How did you assess the financial feasibility of an improvement to alter its highest and best use? Etcetera.
JWV: Yes, and I should add one caveat regarding legal permissibility. Just because property may be zoned for a particular purpose does not necessarily mean that it is impossible to change that purpose. Agricultural land is frequently rezoned as residential subdivisions in the suburbs. Likewise, industrial land is often rezoned for commercial or residential uses in cities. The appraiser really needs to understand development trends in the area and the propensity of the local municipality to revise zoning designations.
Stout Journal: Are there any market conditions or property types for which a reviewer should pay particularly close attention to the highest and best use analysis?
JWV: Yes, basically any time there is a significant change in market conditions – and by that I mean both positive and negative changes. Changes in market conditions bring changes to the underlying economics of particular properties. With appreciating real estate prices, a marginally profitable machine shop may consider a different location. The inability to find a suitable replacement tenant may cause the owner – and the real estate appraiser – to assess whether or not the property should continue as is or be torn down and built to suit trendy retail shops.
Stout Journal: The asset-based approach in business valuation is infrequently utilized. Is that the same with its equivalent in real estate appraisal, the cost approach? If not, how is it or should it be utilized? Under what scenarios is it most likely to be used?
JWV: Of the three approaches, the cost approach is indeed the least frequently utilized. But there are several situations where the approach may be the most relevant – and possibly the only approach which may be applicable. It is often relevant for new construction. In these situations where you have good data on construction costs, any adjustments for depreciation are likely to be minor. Another example is that of special use properties. These properties, which may have been built for a very specific manufacturing process or other need, do not sell very often, so there is limited data outside of a cost approach. It will always depend on the particular circumstance, but without sufficient market data to apply a Sales Comparison or Income Capitalization Approach, the Cost Approach may be the best indication of value.
Stout Journal: Can you please describe in general terms the steps in performing a cost approach analysis?
JWV: In very general terms, starting with the value of the land as if vacant, the cost to replace or reproduce the facility is added. A good question to ask the appraiser is how they derived these cost estimates. What sources were utilized? To this value may be added, depending on the situation, entrepreneurial profit to induce a market participant to build the facility. But be careful here, entrepreneurial profit must be market supported and there must be evidence that it exists.
Stout Journal: The sales comparison approach to me, and I think any person outside of the real state profession, is simply the most intuitive approach. A building is being valued, there is a similar building in the geographic market which sold for a particular amount, and we can infer a value for the property in question from that sale. Is this approach ever not used? And if so, why?
JWV: The main reason this approach may not be utilized is that there is insufficient applicable data. There may be some markets or some property types – again, special use property types are an example – for which there simply are not any comparable sales. The reliability of the approach depends upon the quality and quantity of available data. This certainly has been more of a problem in recent years. Depending on how limited the quality and quantity of data may be, the approach may either be inapplicable or perhaps, still relevant, but to a lesser extent than normal. In those situations, the other approaches may receive relatively greater weighting in the conclusion of value.
Stout Journal: You mentioned quantity of transactions. How many do you require to draw meaningful pricing information?
JWV: Quantity depends on quality. All things being equal, the greater the quality of the comparables, the fewer number of comparables may be necessary. By quality, one certainly needs to look at the properties themselves: location, physical attributes such as overall property size and age, the legal rights conveyed, etc., but it also has to do with information about the pricing. Has the pricing been appropriately verified? Were the financing terms unusual or typical?
Stout Journal: For how long is an appraisal relevant? This question comes up frequently in the context of estate matters whereby an election to use the value six months after the date of death may be made. It is also relevant in litigation. For example in marital dissolutions where each side may be attempting to stipulate as to a valuation date.
JWV: In today’s market, the shelf life of an appraisal may be significantly limited. But it really depends on how the market has performed since the appraisal. And it certainly varies quite a bit by different markets and asset classes. For example, retail has been heavily impacted by the economic downturn, but not necessarily to the same degree in any given market. Properties on the coasts have experienced greater volatility than properties in the Midwest, but not necessarily for any given market or asset class. In general, any reviewer of a report should have a heightened awareness of the possibility that the appraisal is dated – even if we may be talking about a period as short as six months.
SRR Journal: When is the income capitalization approach appropriate?
JWV: For the most part, whenever there is sufficient income data available to result in a reliable indication of value. Oftentimes, it will be the most appropriate and most reliable method of valuing a property. The income capitalization approach consists of two methods: direct capitalization and discounted cash flow. In direct capitalization, a stabilized level of cash flow is capitalized into perpetuity by dividing the estimated net operating income by a capitalization rate to derive value. With the discounted cash flow method, discrete cash flows are projected on an annual basis over a particular holding period, such as five or ten years. The present value of these cash flows are calculated and added to the present value of the property as of the end of the particular period of time utilized.
Stout Journal: Regarding these two different methodologies within the income capitalization approach, when it is appropriate to use one versus the other? And how often, if at all, should a reviewer see both of them at the same time?
JWV: Theoretically, both should produce the same value as they are typically utilizing a lot of the same underlying assumptions. But which one should be employed depends on the expected cash flows. In situations where stable cash flows are expected, for example with long-term leases, there is little reason to use anything other than the direct capitalization approach. This situation is very common with an owner-occupied property. But if there are a number of leases with frequent turnover, or if the property is not fully leased up yet, etc., then cash flows will fluctuate. In these situations, using a discounted cash flow methodology may allow for better flexibility in predicting cash flows and ascertaining the valuation impact.
Stout Journal: Whichever income-based methodology is being used, they follow a basic format: estimate future cash flows and convert those cash flows into a present value equivalent. What are some of the key areas that should be reviewed regardless as to the methodology employed?
JWV: As it relates to “revenue,” or rents, the estimate needs to comport with the interest being valued. The rents applicable to a fee simple interest may be very different from the rents applicable to a leased fee interest. The former will be driven by market rents while the latter will solely incorporate current contractual rates. In times of changing market conditions, this may have a profound impact on value even when comparing similar times periods. Vacancy is obviously another key assumption that needs to have sound historical and/or market-based support. As it relates to expenses, a key assumption involves reimbursements for or the pass through of expenses such as maintenance of common areas, taxes, etc. So the terms and conditions of leases, both current and prospective, are a major assumption. Subtracting expenses from revenue generates net operating income to which is applied the capitalization or discount rate, depending on which methodology is employed.
Stout Journal: Where do the capitalization and discount rates come from? That is, how is it determined and how should it be documented within the report?
JWV: Capitalization and discount rates are critical assumptions, and there absolutely needs to be strong support. This is an area where appraisers often fall-short – relying on unsupported assumptions about rates. For support, there are a number of resources available. First, comparable transactions imply overall capitalization rates. It can be calculated by dividing net operating income by the sale price. Second, investor surveys and conversations with participants in the market provide current expectations of investors, so in some respects this may provide more timely data on which to base assumptions. Lastly, rates can be derived from a band of investment analysis. This analysis reviews current financing terms that provide information on various sources of capital. The analysis looks at both the cost of debt and equity, which are then weighted to derive an overall capitalization rate, which implies an overall rate of return on and of the investment in real estate. Using all of these sources and weighing their relative merits at this point in time and for this particular property will allow the appraiser to determine capitalization or discount rates.
Stout Journal: What is the difference between a capitalization rate and a discount rate? Do they derive from different sources? Do they measure the same thing?
JWV: No, they are different, but they share a key attribute. Theoretically, the discount rate is the “return on” an investment required by an investor for a given level of risk. A capitalization rate, however, reflects both the “return on” and “return of” the investment required by the investor. This is another area to review: Has the appraiser been consistent if both a capitalization rate and a discount rate been presented? The investor surveys I previously mentioned tend to be the best sources for discount rates – this is what investors are looking for today as a return on their capital. Sales of comparable properties can be great sources for capitalization rates. So an area to review is whether the assumptions on capitalization and discount rates are appropriately supported.
Stout Journal: In reconciling the different approaches – cost, sales comparison, and income capitalization – I assume in general you prefer to see some consistency between their respective conclusions, but what happens if you do not? How do you derive a conclusion of value given that circumstance? Essentially, how do you reconcile the various methodologies – with or without consistency?
JWV: All things being equal, you would like to see them be within a reasonable range of each other. If they are not, the first course of action is to recheck the underlying assumptions of each approach. But, ultimately, it comes down to deciding which methodology should receive the most weight, which one is the best indication? The answer really comes down to a couple of things. First how are the relative qualities and the quantities of the data available for each method? If you have a lot of great sales, then a sales comparison approach could be a very powerful, reliable approach. Second, one should always keep in mind how an investor will look at the property. If cash flow is the primary driver, then the income capitalization approach may be most reliable. A lot of this goes back to highest and best use.
Stout Journal: Do you have any concluding comments?
JWV: I encourage all attorneys to look beyond the “Pretty Report” and take a closer look at the underlying analysis. Whether you are getting ready to cross-examine a witness or trying to get comfortable with your own expert, taking a critical look at the appraisal can make or break your case.